Royalty Payments Not Subject to Capitalization Under Sec. 263A

A recent Second Circuit decision provides
a potential opportunity for taxpayers that will incur
royalty payments to structure the agreements in such a
manner that they can immediately deduct royalty costs
instead of capitalizing them under the uniform
capitalization rules of Sec. 263A. In Robinson Knife Manufacturing
Co., No. 09-1496-ag (2d Cir. 3/19/10), the court
ruled that a taxpayer involved in manufacturing could
currently deduct trademark licensing royalty payments if
the payments were calculated as a percentage of sales
revenue from certain inventory and were incurred upon the
sale of that inventory. The court’s interpretation of Sec.
263A and the regulations thereunder may give taxpayers an
opportunity to structure licensing and franchise
agreements in such a way that they may deduct royalties
paid under such agreements currently instead of
capitalizing them to inventory.

Costs
Allocable to Inventory

Sec. 263A provides that in
the case of property that is inventory in the hands of a
taxpayer, certain direct and indirect costs otherwise
deductible by the taxpayer must be capitalized as
inventory costs. The taxpayer generally recovers the
capitalized costs as it sells the inventory. Sec. 263A
applies to property produced by the taxpayer or property
acquired for resale.

Sec. 263A provides that
inventory costs include direct material and direct labor
costs as well as an allocation of indirect costs. The
regulations define indirect costs as all costs other than
direct material and direct labor costs or acquisition
costs that directly benefit or are incurred by reason of
the performance of production activities. When indirect
costs are also allocable to other activities not subject
to Sec. 263A, the taxpayer must make a reasonable
allocation of indirect costs between production and other
activities.

The regulations list examples of indirect
costs that are inventoriable to the extent they are
properly allocable to produced property or property
acquired for resale. Allocable indirect costs include
certain taxes, depreciation, and environmental remediation
costs, among other costs. Also listed are licensing and
franchise costs, as discussed below. Taxpayers must
analyze their costs to determine whether the costs
directly benefit, or are incurred by reason of, a
production activity. The regulations also specifically
provide that certain costs, including marketing, selling,
advertising, and distribution expenses, are not subject to
capitalization and are therefore currently deductible.

Licensing, Franchise, and Royalty
Costs

Indirect costs, such as licensing, franchise,
and royalty payments, may relate to both inventory and
noninventory operations; as such, they must be analyzed to
determine whether the costs relate to inventory
operations. The regulations specify that allocable
indirect costs include licensing and franchise fees
incurred to secure the contractual right to use a
trademark, corporate plan, manufacturing procedure,
special recipe, or other similar right associated with
property produced or acquired for resale. Such costs
include the otherwise deductible portion of the initial
fees incurred to obtain the license or franchise
agreement, generally recovered through amortization. In
addition, allocable costs include any minimum annual
payments and royalties that are incurred by a licensee or
franchise to the extent related to production activities
(Regs. Sec. 1.263A-1(e)(3)(ii)(U)).

Before the
Second Circuit addressed the issue in Robinson Knife, there
was very little guidance on the treatment of royalties
paid pursuant to license and franchise agreements under
Sec. 263A. The only prior published opinion was a Tax
Court decision that ruled against the taxpayer (Plastic Engineering &
Tech. Servs., Inc., T.C. Memo. 2001-324). In
Plastic
Engineering, the Tax Court addressed whether the
taxpayer was required to capitalize certain royalties paid
as the exclusive licensee of a patented hot manifold
assembly system, with royalties equal to 10% of the net
sales price of all plastic molded products manufactured
through the use of the patented assembly system. The Tax
Court ruled that the royalty payment at issue related to a
manufacturing procedure and that royalty payments made for
a patented manufacturing process are inventoriable costs
under Sec. 263A even through the royalty was contingent
upon the selling of the goods. The taxpayer argued that
the regulations under Sec. 263A covered only “minimum”
royalties and not contingent royalty payments. However,
the Tax Court ruled that the taxpayer’s argument was
flawed and that the regulations clearly addressed indirect
licensing and franchise costs as allocable costs, and the
regulation’s reference to minimum annual royalties was
only an example of such costs.

Relying on Plastic Engineering,
the IRS reached a similar conclusion in Technical Advice
Memorandum 200630019. In that ruling, the IRS held that a
subsidiary must capitalize royalty payments to its parent
for the right to use certain intellectual property
necessary to conduct production activities.

The Tax Court in
Robinson Knife
followed a similar pattern. Robinson Knife is a
corporation engaged in the business of designing,
developing, manufacturing, marketing, and selling kitchen
tools, which it markets and sells to large retailers.
Because many kitchen tools have similar characteristics,
Robinson Knife often enters into trademark licensing
agreements with well-known names in order to differentiate
its product (if in name only) from other products on the
market.

Robinson Knife’s general production process
is as follows. Robinson Knife develops an idea for a new
product. It then decides which trademark, if any, would be
the most appropriate to couple with the idea and designs a
new tool. After Robinson Knife has both the design and the
trademark license approval, it contracts with a third
party to manufacture the product. Robinson Knife may also
produce an identical product that does not bear the
licensed trademark.

For products with a licensed
trademark, the packaging either identifies only the
licensed trademark or, if Robinson Knife’s name is also on
the package, the licensed trademark is more prominently
displayed. Robinson Knife often relies on the reputation
of the licensed trademark to differentiate the product at
the point of sale.

The case involved two licensing
agreements that were identical in all pertinent terms.
Under these agreements, Robinson Knife had the exclusive
right to manufacture, distribute, and sell certain types
of kitchen tools using the licensed brand names. Robinson
Knife was required to pay to the trademark owner a
percentage of the net wholesale billing price of the
kitchen products bearing the trademark. Robinson Knife did
not have any obligation to make a royalty payment until a
kitchen product was sold and was not required to make any
minimum or lump-sum royalty payment. Under this
arrangement, Robinson Knife would not owe any royalties if
it did not sell the trademarked products it produced.

Robinson Knife, which was an accrual-method taxpayer,
sold some of the products bearing the trademark and paid
the resulting trademark royalties. It deducted the
royalties incurred and paid as ordinary and necessary
business expenditures. The IRS determined after
examination that the company should have capitalized the
payments under Sec. 263A.

The Tax Court ruled
against the taxpayer, holding that the royalty payments
are indirect costs that were required to be capitalized
under Regs. Sec. 1.263A-1(e)(3)(ii)(U). The court found
that Robinson Knife incurred the royalty costs “by reason
of the production activities” because “without the license
agreements, [Robinson Knife] could not have legally
manufactured” the kitchen products. In addition, the Tax
Court noted that the marketing benefit generated by the
trademarks (i.e., brand recognition at the point of sale)
did not alter the fact that the royalty fees permitted
Robinson Knife to use the trademark during the production
process. Finally, the court cited Plastic Engineering
for the proposition that the fact that the royalty
payments were tied to actual sales was not a determining
factor.

Robinson Knife made three alternative
arguments on appeal to the Second Circuit:

The royalty payments are deductible under Regs. Sec.
1.263A-1(e)(3)(iii)(A) as advertising or marketing
expenses;

Royalty payments that are not
incurred in securing the contractual right to use the
trademark are always deductible; and

The
royalty payments at issue were not “properly allocable
to the property produced.”

The Second
Circuit held for Robinson Knife based on the third
argument. Specifically, the court held that royalty
payments that are calculated based on a percentage of
sales revenue from certain inventory and that are incurred
only upon the sale of such inventory are not required to
be capitalized under the Sec. 263A regulations. The Second
Circuit dismissed Robinson Knife’s first two arguments as
being overbroad; taken to a logical conclusion, each would
require the court to rule that all trademark royalties
were exempt from capitalization, which the court felt was
incorrect.

In reaching its conclusion, the Second
Circuit found that the Tax Court had asked the wrong
question required by the regulations: The court had asked
whether Robinson Knife’s license agreements directly
benefited the production process when it should have asked
whether the royalty payment costs directly benefited the
production process. The regulations require capitalization
if the costs directly benefit or are incurred by reason of
the production process. As such, according to the Second
Circuit, if the Tax Court had asked the right question, it
would have found that the royalty payments had nothing to
do with the production process. Robinson Knife could have,
and did, manufacture the products without having to pay
any royalty payments. The payments became due only when
the company sold the products. “[I]t is the costs, and not
the contracts pursuant to which those costs are paid, that
must be a but-for cause of the taxpayer’s production
activities in order for the costs to be properly allocable
to those activities and subject to the capitalization
requirement.”

The Second Circuit also made an analogy
to regulatory and legislative history regarding the sales
of books; this history directly addressed payments due
upon sale. Regs. Sec. 1.263-2(a)(2)(ii)(A)(1) notes that
the costs that must be capitalized for developing and
producing books do not include “commissions for sales of
books that have already taken place.” Because the royalty
payments at issue were also sales based and incurred only
on the sale of the product, Robinson Knife similarly was
not required to capitalize the payments. The court noted,
however, that it was possible that a future taxpayer could
draft a royalty agreement that in form met the
requirements set forth (i.e., based on sales and incurred
upon sale) but in economic reality related to products not
yet sold; that was not the case here.

The Second
Circuit did not directly address Plastic Engineering
and simply mentioned it in passing as the only other case
it had found that discussed whether royalty payment costs
are capitalizable under Sec. 263A. Assuming that Plastic Engineering
remains good law in some or all jurisdictions, a
distinguishing factor would be that the rights at issue in
Plastic
Engineering actually permitted the taxpayer to
conduct the manufacturing process (i.e., in a but-for
case, the production process itself could not have
occurred without the royalty agreement). In Robinson Knife, the
rights were not associated with the actual ability to
conduct the production process.

Planning Considerations

The Second
Circuit’s holding provides planning opportunities for
taxpayers entering into royalty payment agreements.
Provided that the economics make sense and that the
taxpayer has not previously adopted a method of accounting
that capitalizes the sales-based royalty payments,
taxpayers may be able to structure the agreements in such
a way that royalties paid under the agreements may be
currently deducted instead of capitalized to inventory.
The taxpayer making the royalty payments should avoid
agreements to make two types of payments:

Lump-sum minimum royalty payments based on a
specified payment that does not vary regardless of the
number of trademarked items manufactured or sold; and

Instead, the taxpayer
making the royalty payment would prefer an agreement to
make royalty payments that are sales based and that do not
directly benefit and are not incurred by reason of the
performance of production activities. The taxpayer’s
royalty payments should be calculated as a percentage of
sales revenue and should be incurred only upon sale of
that inventory. In addition, the royalty payments should
be based on products sold in the current period and not on
products to be sold in the future. Taxpayers who have
already adopted a method of accounting that capitalizes
sales-based royalty payments should analyze whether there
are opportunities for filing for a change in accounting
method.

The Second Circuit’s opinion appears to stand
for the broad proposition that any sales-based royalty
payments that the taxpayer incurs only at the point of
sale are not subject to capitalization. Assuming that this
holding is adopted by other jurisdictions and by the IRS
(the IRS has not yet announced its plans after the
opinion), an unanswered question is whether royalty
payments such as those in Plastic Engineering
would also be deductible. That is to say, would royalty
payments that are based on sales and incurred only at the
point of sale but that are also related to rights that are
fundamentally necessary to conduct the production process
be deductible? It is unclear whether the Second Circuit
has implicitly added a third requirement for
deductibility—i.e., that the right granted by the
agreement not be necessary to conduct the production
process itself. In
Robinson Knife, the taxpayer could have produced
the exact knife though without the licensed trademark. In
Plastic
Engineering, the taxpayer could not have conducted
the manufacturing without the licensed right.

Conclusion

Taxpayers may have the
opportunity to structure licensing and royalty agreements
so that they can deduct royalty payments as ordinary and
necessary business expenses. These types of payments can
be substantial for taxpayers that produce inventory or
acquire inventory for resale. Taxpayers and their advisers
should analyze the specific facts applicable to their
businesses and agreements and determine whether they can
make an argument for currently deducting royalty payments
that are not associated with the production process.

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